A recent case from Federal Tax Court slapped an innocent taxpayer with taxes on a $114,000 worth of income that he wasn’t expecting – plus an additional $11,400 in excise taxes for the “early withdrawal” penalty, since he wasn’t age 59½ yet.
Here’s what happened:
A taxpayer named Guy Dabney had an IRA account at Charles A. Schwab & Co., – a well known and respected investment company and popular IRA custodian. Mr. Dabney was attracted to the advantages of self-directed IRA investing, and after conducting research himself online and finding that tax rules allowed it, he bought real estate with funds from his IRA at Schwab. Specifically, he bought some land in Utah.
Dabney contacted Schwab and directed them to wire $114,000 from his IRA directly to the seller – so Dabney never took possession of the funds. Furthermore, Dabney also had the property titled in the IRA’s name, rather than his own.
This was altogether right and proper under the law and under IRS rules. The problem: It didn’t work.
Not all IRA custodians are equal
Schwab has a long track record of success as a mass-market investment company and is very good at serving the mass market, which invests almost wholly in financial products like mutual funds, stocks, bonds and money markets. The mass market is its core competency and the heart of its business model. But their expertise does not extend to non-traditional assets, asset classes and self-directed retirement investing.
They themselves are aware of this, of course, and therefore do not even deal with self-directed accounts at all. You can buy traded REITs in a Schwab account, and REIT funds, but they just don’t do self-directed real estate IRAs. Their internal policies don’t allow for it, and there’s nothing in the law that says they have to act as custodian for these kinds of accounts.
As a result, they wound up accidentally titling the Dabney’s land in his own name, rather than in the name of the IRA (a bookkeeping error they later corrected), and then treating the entire amount as a distribution.
They even sent Dabney and the IRS a 1099 – R form stating he had actually taken a taxable distribution of $114,000 – generating the immediate tax liability plus a 10 percent penalty.
Wait – it gets even worse:
Dabney later sold the land for $127,226, and directed the money be wired back into his Schwab IRA account. Indeed, it appears that he wasn’t truly aware or cognizant of the fact that his money was no longer in the Schwab IRA. Schwab loves having assets under management, naturally, and so they accepted the money. But because the source of funds was a taxable account, and not a tax-advantaged retirement account such as an IRA or 401(k), Dabney wound up making a huge excess contribution to his IRA – and exposed him to a 6 percent penalty every year the money remains in the IRA. That would result in a tax bill of about $7,000 each year.
Think the courts would give him a break? In a way, they did: The courts disallowed a 20 percent “accuracy-related” penalty on the basis that Dabney’s actions were “reasonable,” based on his online research. So it’s not as bad as it could have been, but he will still have a substantial and needless tax bill that could have been avoided had he used American IRA, LLC, to handle the transaction.
A better way
The way to avoid Self-Directed IRA Penalties and the problem that Dabney encountered is to verify that your IRA custodian will even handle self-directed retirement accounts to begin with – and what kinds of assets, specifically, they will accept. Had Dabney checked with Schwab first – and believed them about their own internal policies – he may well have taken a different course of action. For example, he could have opened an account with American IRA, rolled the IRA funds from Schwab directly into his American IRA account, and then directed us to have his IRA purchase the property from the seller on his behalf.
The difference, of course is in our core competencies: At Schwab, Mr. Dabney’s situation fell well outside of the kind of accounts a mass market investment company is set up to handle. But American IRA, LLC, these kinds of accounts are what we do best. We make it our business to become experts on the unique aspects of self-directed retirement investing and to serve these non-traditional retirement investors. The difference isn’t just in the smoothness and efficiency of a transaction – it’s also in heading needless penalties and taxes off at the pass. As you can see from this example, using a custodian that specialized in real estate IRAs and other non-traditional IRA investments could have saved Mr. Dabney tens of thousands in taxes and Self-Directed IRA Penalties, and who knows how much in legal fees as the case wound its way through the court system, racking up billable hours all along the way.
Are you considering non-traditional IRA investing? Or using self-direction in an IRA or another type of retirement account? Don’t go it alone! There are a number of things to consider and to be sure of before you make a single move. Call us first, at 866-7500-IRA (472) or visit us at www.AmericanIRA.com. We can help you avoid a lot of trouble down the road – and put your retirement security on a much firmer footing.
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